Stock market volatility often involves big swings in both directions and this episode has been no different. Since the recent market low at the end of March, the S&P 500 has risen 25% and the Dow nearly 28%. While each index is still in the red for the year at -14% and -17%, respectively, this highlights how unpredictable markets can be on a short-term basis. What, then, can investors rely on to navigate markets as the coronavirus-induced economic crisis unfolds?
In the long run, the best North Star investors have are valuations. While nothing perfectly forecasts stock market movements, especially in the short run, buying when the market is cheap is one of the best ways to increase the odds of higher returns over the course of years and decades. This is especially true when investor sentiment is overwhelmingly negative and the world seems full of risks. In many cases, higher returns are a reward for bearing these risks.
Most valuation measures simply use the price of an index, e.g. the S&P 500, divided by some fundamental measure, e.g. earnings, sales, book value, etc. For instance, the price-to-earnings (P/E) ratio tells us how many dollars we are paying for each dollar of earnings. Comparing this to a historical average can tell us whether the market is cheap or expensive relative to what investors have paid in the past.
In many cases, stock prices fall independently of changes in underlying fundamentals. While stock prices can move wildly over days and weeks, economic growth trends evolve over quarters, years and decades. Thus, fundamentals can serve as a fixed navigation point by which long-term investors can steer their asset allocations.
Today, the challenge is knowing what the "true" valuation of the market is. This is akin to navigating under a cloudy sky - the stars are there but obscured. This is because while stock prices have fallen, we don't have accurate, real-time data on the economic slowdown and its effects on sales, earnings, and other fundamental measures. Even if we did, the fact that earnings projections are more uncertain also has a negative impact on the present value of those earnings.
Just as navigating by the stars involves as much art as science, and relies heavily on the navigator's experience and disciplined process, so too is interpreting valuations in this environment. Fortunately, experience tells us that we know more than what the economic data alone suggest.
While there is significant uncertainty around the coronavirus, the epidemiological curve, and the exact economic impact of the nationwide and global shutdowns, we can be fairly sure of three facts.
First, the economy was healthy entering this crisis with historically low unemployment and steady growth. Second, it seems likely that the economy will re-open based on the experience of other countries - and on countless past experiences in the U.S. Of course, this depends on public health considerations which, unfortunately, create a trade-off with economic ones. Third, the economic data are a trailing indicator of what has already occurred, rather than a forecast of what will occur.
Thus, experience tells us that when businesses eventually re-open, their sales and earnings should be able to slowly get back on track. The better managed the damage to individual and business balance sheets is, the better the outcome will be (government support will be critical here, like it or not). Some businesses may not survive while others may thrive in the new environment. There may even be pent-up demand and excess capacity that accelerates growth in certain areas as well.
Although there is cause for optimism, it may take some time for this to play out. Luckily, investing is a long-term activity where time is the crucial ingredient. Although there may be a significant hit to earnings growth for companies in the coming weeks and months, it's important to instead focus on how companies will perform once work can resume and demand returns. For companies whose earnings-generating abilities can recover within months of the crisis, current valuation measures are still an invaluable gauge for steering portfolios.
Below are three charts that help to put the uncertainty around current valuation levels in perspective.
1. The market's P/E ratio has fallen to historical averages
Stock Market Price-to-Earnings
The S&P 500 forward P/E ratio (using next-twelve-month earnings) has fallen to its historical average level of 15.2x. This is a significant decline from February when the market reached all-time highs and valuations were at their cycle peak.
This valuation measure relies on estimates for forward earnings. It's unclear how those estimates will evolve as the economic crisis unfolds. However, if the economy can re-open in the coming months, then it's likely that sales and earnings can slowly get back on track.
2. Valuation measures across the board have fallen from recent highs
Stock Market Valuations
These dynamics around valuations can be seen across a wide variety of measures. There is significant uncertainty around forecasts for these fundamentals, but they do all point to a market that is much cheaper than it was just two months ago.
3. Estimates of earnings and other fundamentals are uncertain
S&P 500 Earnings Growth Rate
Earnings estimates will undoubtedly fall in the coming weeks - if they can be measured accurately at all. Still, this is a trailing indicator since we already know this will occur. Instead, investors should focus on the recovery in earnings once this crisis is over, and the impact that it will have on valuation measures.
The bottom line? The stock market appears to be significantly cheaper today than just two months ago. Although there is uncertainty in measuring fundamentals at the moment, it's clear that the economy will eventually re-open and businesses will slowly get back on track.